Journal of Revenue and Pricing Management Volume 4 Number 1
Dynamic pricing — A future airline
business model
Beat Burger and Matthias Fuchs*
Received: (in revised form): 3rd November, 2004
*Centre for Tourism and Service Economics, University of Innsbruck, A–6020 Innsbruck, Austria
Tel: +43 512 507 7083; Fax: +43 512 507 2845; E-mail: Matthias.fuchs@uibk.ac.at
Beat Burger is currently working on his
PhD, on the subject of dynamic pricing for
airlines. He studied business administra-
tion and law at the University of Bern
Matthias Fuchs is Professor at Centre for
Tourism and Service Economics at the Uni-
versity of Innsbruck, Austria. In 2003, he
finished his habilitation in business admin-
istration at the University of Innsbruck,
Austria. In the same year he was nomi-
nated for the ‘Eminent Scientist of the Year
2003’ by the World Scientist Forum and the
International Research Promotion Council,
2003, Kerala, India. Areas of research
include benchmarking, e-tourism and
labour market research. At present, he is
also the director of the eTourism Compe-
tence Center Austria, Innsbruck.
ABSTRACT
KEYWORDS: dynamic pricing, airline rev-
enue management, pull strategy, distribu-
tion chain
This paper examines the economic effects of a
dynamic pricing strategy for the airline industry.
It is shown that a seat on a specific flight is a
typical perishable good, appropriate to be dyna-
mically priced. The application of a dynamic
pricing strategy has a neutral or a positive effect
on revenues, depending on competitors’ revenue
management strategy. Furthermore, a dynamic
pricing strategy not only influences revenue but
also affects the cost structure of an airline and,
hence, leads directly to a decrease in process
complexity and transaction cost. Therefore,
dynamic pricing proves to be the starting point
for an efficient pull strategy. It follows that a
dynamic pricing strategy can probably lead to a
new business model for the airline industry.
INTRODUCTION AND OVERVIEW
Revenue management is a practice that
dates back to the deregulation phase of the
airline industry in the late 1970s (Winston,
1986). It has been developed as an out-
growth from the need to manage capacity
sold at discounted fares, targeted at leisure
travellers, while simultaneously minimising
the dilution of revenue from business tra-
vellers who were willing and able to pay
full fare. The seat inventory control pro-
blem for a single-leg flight with multiple-
fare classes has been studied extensively in
the literature. The latter distinguishes
between a static and a dynamic version of
this problem. The static version assumes
that demand for different fare classes
arrives sequentially so that all booking
requests for the lowest classes come first,
followed by all booking requests for the
next lowest class, etc. Seat inventory con-
trol has been implemented by imposing
booking-limit calculations and a demand
model for each fare class. Belobaba (1987, Journal of Revenue and Pricing
Management, Vol. 4, No. 1, 2005,
1989), Brumelle and McGill (1993), Curry pp. 39–53
# Henry Stewart Publications,
(1990), Littlewood (1972), Li and Oum 1477–657X
Page 39
Dynamic pricing — A future airline business model
(2002), Robinson (1995) and Wollmer
(1992), among others, have studied the
static problem. Within the dynamic pro-
blem, demand for each class is modelled as
a stochastic process. An airline needs to
decide whether to accept or reject each
individual booking request based on the
number of unsold seats and the remaining
time to departure. Thus, the optimal
inventory control policy is typically deter-
mined by dynamic programming. Lee and
Hersh (1993) were the first to study this
problem. Their model has been extended
to incorporate issues such as overbooking,
cancellations and no-shows (eg Chatwin,
1996, 1998; Subramanian et al., 1999). Lau-
tenbacher and Stidham (1999) provided a
unified model for the static and dynamic
problem.
A central revenue management premise
is that demand is perfectly segmented
(Belobaba, 1987). Typically, it is assumed
that booking requests are made for one
special fare class and, if the request is
turned down, the potential customer is
lost. The likelihood of selling a full-fare
ticket, however, may well depend on
whether a discount fare is available at the
time. Put differently, product substitution
is to be expected as passengers try to get
the lowest fare that still meets their needs
(Talluri and van Ryzin, 2000). Because
of this product substitution, forecasts will
progressively underestimate high-yield
demand and at the same time will overesti-
mate low-yield demand. Therefore, it can
be shown that traditional revenue manage-
ment systems spiral down to the lowest
fare class and do not generate an optimal
decision support (Cooper et al., 2004). In
addition, low-cost carrier competition has
increased dramatically over the last few
years (Ito and Lee, 2003). The latter have
introduced radically different pricing poli-
cies, which contradict traditional pricing
theory (Lawton, 2002). Restrictions such as
Saturday nights or minimum-stay rules
Page 40
were removed and one-way pricing has
become possible. The only segmentation is
effected through time of booking and
choice of flight. Those who want to get a
cheaper seat must book earlier and/or on
weaker-demand flights. Today, many tra-
ditional airlines are starting to react to this
low-cost competition and starting to sim-
plify their fare structures. Simulation, how-
ever, has shown that just simplifying an
airline’s fare structure by cutting the
restrictions can lead to a decline in revenue
of more than 30 per cent (Gorin, 2003).
This paper broadly evaluates dynamic
pricing effects for the airline industry. First,
it is shown that an airline seat may be
dynamically priced. Secondly, a basic
dynamic pricing prototype model is intro-
duced. Thirdly, the performance of an air-
line’s dynamic pricing strategy is
hypothesised and systematically tested. It
can be demonstrated that a dynamic pri-
cing strategy not only influences the air-
line’s revenue but also positively affects its
cost structure. Hence, the conclusion fol-
lows that a dynamic pricing strategy can
probably lead to a new airline business
model in the future.
DYNAMIC PRICING
The dynamic pricing concept is not
entirely new. Depending on one’s view, it
is either the most natural or the most
extreme approach to price-responsive
demand. As the economist Paul Krugmann
(2000) pointed out, dynamic pricing is
merely a new version of the age-old prac-
tice of price discrimination. Yet, what is
new about today’s form of price discrimi-
nation is that current technology has made
dynamic pricing not only widely possible,
but also commercially feasible (Elmaghraby
and Keskinocak, 2002).
In the 1980s, US electricity suppliers
started to set electricity prices in relation to
demand. The most feasible way to do so
was by the implementation of time-of-use

(ie TOU) rates or dynamic pricing. This
allowed utilities to pass on to consumers at
least part of the price variation occurring
within a given period, thus decreasing
demand when supplies are tightest. Once
exposed to electricity prices that vary
during the day, consumers are likely to
alter their consumption patterns, especially
during critical peak periods. Experiments
with dynamic pricing in Texas have shown
that consumers shifted or curtailed almost a
third of their demand during peak periods
(Colledge et al., 2002).
Indeed, dynamic pricing emerged as a
business strategy that adjusts the product
price in a timely fashion in order to allo-
cate the right service to the right customer
at the right time. If prices are viewed as
variable and can be controlled on a contin-
uous basis, product prices can be set dyna-
mically in order to maximise expected
total revenues (Kincaid and Darling, 1963).
So-called perishable goods are especially
suitable to be priced dynamically (Christo-
pher, 1984). As with electricity, perishable
products feature the following characteris-
tics:
(1) The quantity is fixed and reordering is
not possible.
(2) There is a deadline for sales.
(3) The marginal cost of selling one or
more items is low.
Applying these characteristics to the air
travel industry may show that a seat on a
specific flight is also a typical perishable
good (Lin, 2003). Once an aircraft is
defined for a specific flight, the quantity of
seats is fixed. At the time the aircraft
departs, any unsold seat is valueless and can
no longer be sold. In the air travel indus-
try, marginal sales cost is very low. It is
obvious that a seat on a specific flight can
be dynamically priced. Therefore, instead
of pricing different products represented by
booking classes, seats can also be priced
Burger and Fuchs
dynamically directly in relation to demand.
Product differentiation will be done only
over the factors ‘time to departure’ and
‘demand in relation to capacity’. In other
words, dynamic pricing responds directly
to market demand by offering an optimal
or nearby optimal market fare (Lin, 2003).
Most existing literature consisting dynamic
pricing assumes that both customer arrival
rate and customer reservation price distri-
bution are well known before the sale
begins (McGill and van Ryzin, 1999).
In many service industries, however, the
seller can only use historical data to esti-
mate the customer reservation price.
Through preliminary pre-sales market
research, an airline obtains a prior distribu-
tion of the customer arrival rate. As the
sale moves forward, the airline may use
real-time sales data to update the demand
distribution and then dynamically set
prices. The set price then interacts with the
demand behaviour and may control capa-
city. High capacity and low demand will
immediately lead to reduced prices. Thus,
the remaining seats will be sold either at
the expense of competitors or as a result of
increased ‘low-price demand’ (Binggeli and
Pompeo, 2002). Inversely, high demand on
specific flights will increase fares immedi-
ately to protect seats for passengers book-
ing closer to departure with a higher
willingness to pay. Hence, dynamic pricing
methods do not determine a booking con-
trol policy at the start of the booking
period as the static methods do (Weather-
ford and Bodily, 1992).
Applying price elasticity of demand
instead of restrictions to control capacity is
a rather new approach, and the application
has not yet been systematically evaluated in
the air transportation industry.
MODEL BUILDING ISSUES
In this section, a dynamic pricing proto-
type is introduced according to Isler (2003).
The objective of the prototype model is to
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Dynamic pricing — A future airline business model
evaluate the performance and economic
effects of a dynamic pricing strategy in the
air transportation industry. The model
structure consists of a market model, an
optimiser and a forecaster.
Market model
It is considered that a supplier sells a given
stock of a product over a finite time hori-
zon [0, T] and the customers’ arrival rate
corresponds to a discrete binomial distribu-
tion based on a Bernoulli trail (Mood et al.,
1974). Upon arrival, a customer will pur-
chase one item if the posted product price
is lower than or equal to his/her willing-
ness-to-pay, otherwise he/she leaves
‘empty-handed’. It is assumed that willing-
ness-to-pay of all customers is independent
and stochastically distributed with a contin-
uous cumulative function with a fixed set
of prices fi (i=1, . . ., F, such that fk>fj if
k>j). The assumption that the seller can
choose any price from a continuous set
possesses some mathematical elegance, but
may not be practical in some cases (Lin,
2003). The seller has an incentive to restrict
the price to be chosen from a discrete price
set, such as 99, 119, 129, 139, etc., for var-
ious marketing reasons, including the sub-
jective perception of prices (Monroe,
1973).
For each arrival, the probability that the
customer will pay fare f is given by prob-
ability p(f). It is assumed that p(f) is strictly
decreasing and satisfies
pðfk Þ
pðfj Þ if k > j ð1Þ
Assumption (1) reflects the market model
and allows the interpretation of the sell-
er’s decision successfully to sell one item.
Sales end either when the seller is out of
stock, or at time T. It is further assumed
that any unsold product at time T has no
salvage value. This assumption is without
loss of generality if the salvage value of
the stock is linear with the number of
Page 42
unsold products. The selling interval is
divided into steps, such that the probabil-
ity of multiple arrivals within a specific
time interval is negligible. The demand
rate for an interval is denoted by p0 and,
consequently, demand d is equal to p0T.
Letting demand d be within a specific
selling interval denotes the probability of
an arrival at the given fare fi. Corre-
spondingly, the probability of no arrival
is
ð1  p0 Þ þ p0 ½1  pðfi Þ ¼ 1  pi
It is clear that the probability of a no arri-
val corresponds to the inverse arrival prob-
ability of one buying passenger pi at the
given fare fi in a specific time interval.
Optimiser
Dynamic programming is the only exact
and efficient technique available for sol-
ving the problem of optimisation over
time in the general non-linear, stochastic
case. Dynamic programming is based on
Bellman’s principle of optimality (Bellman
and Kalaba, 1965). It argues that an opti-
misation problem can be solved by recur-
sively solving Bellman’s equation to find
time-consistent policy functions. Applying
dynamic programming on a single-leg
problem and based on the above market
model, the expected total revenue J in
stage t and with the capacity x can be
formulated as {pi ½fi þ Jt ðx  1Þþ
ð1  pi ÞJt ðxÞ}, where ½fi þ Jt ðx  1Þ repre-
sents the case of a buying passenger and
ð1  pi ÞJt ðxÞ stands for the situation where
no customer arrives or a passenger leaves
‘empty handed’.
It is easy to see that, if fare fi is set in
order to maximise the expression at every
time stage t, the expected total revenue
Jt(x) will be maximised over time. This
relation is given in equation (2), referred to
as the Bellman equation for a single-leg
revenue management problem

Jt1 ðxÞ ¼ maxfpi ½fi þ Jt ðx  1Þ
i
þ ð1  pi ÞJt ðxÞg ð2Þ
¼ Jt ðxÞ þ maxfpi ½ðfi 
Jt ðxÞÞg
i
where

Jt ðxÞ  Jt ðxÞ  Jt ðx  1Þ

Jt ðxÞ represents the opportunity cost of
selling one unit of capacity. Equation (2)
can be solved by iteration for the boundary
condition
Jt ðxÞ ¼ Jt ð0Þ ¼ 0
The customer arrival rate is not known in
advance. Hence, as soon as sales begin, the
airline starts to predict the future demand
distribution. The seller’s objective is to use
real-time sales data to adjust the product
price dynamically in order to maximise the
expected total revenue.
Forecaster
To estimate the dynamic probabilities P ^i ,
the maximum likelihood method is
applied. As the latter is invariant under
linear transformations, it leads to unbiased
estimators (Bickel and Doksum, 1977). If
an initial point is carefully selected, the
non-linear algorithm will converge to a
satisfactory local maximum. Consequently,
the dynamic probability is available to feed
the optimisation algorithm. Since the prob-
ability of an arrival depends on the control
variable fi , the forecast must be state con-
tingent.
If there were enough observations of
arrivals N i or no arrivals for each fare, the
estimator would read ^pi ¼ NiNþiN i. Con-
straint (1), however, will not necessarily be
satisfied. It has to be imposed as a particular
constraint to the likelihood maximisation.
It is supposed that the estimator is deter-
mining all probabilities to zero, except for
the lowest fare. Then, the optimiser will
display the lowest fare only, and there will
never be any corrections to those estimates.
Burger and Fuchs
Unlike traditional dynamic pricing models,
where the seller has to know the custo-
mer’s arrival rate in advance, a key
assumption in this model is that the seller
estimates the demand. Therefore, pre-sales
market research is proposed to reveal the
first two moments of the demand distribu-
tion. Consequently, if the seller can accu-
rately predict the first customer’s p(f), the
risk of ending up in a ‘self-fulfilling pro-
phecy’ is reduced to a minimum. As sales
move forward, the seller collects sales data
in real time to model the demand curve
and to ‘fine-tune’ customer arrival rates.
Comparison with standard
revenue management
Standard revenue management assumes
that the demand is perfectly segmented
into different products at fare fi (Belobaba,
1987). Nested allocations or bid price con-
trols allow sales at given fare fi and above.
The difference from the above model is,
however, that sales at fares >fi are
expected as well. Replacing the quantities
pi, and fi in (2) by

X
F
Pi ¼ Pj
j¼i
 1X F
fi¼  pj f i
p i j¼i
the same optimisation algorithm solves the
standard problem as well (Lautenbacher
and Stidham, 1999). The arrival rates are
multiple counted, and the fares are overes-
timated because ‘buy down’ is neglected.
Conversely, the forecast for standard rev-
enue management systems is not state con-
tingent. The estimator would add
superficial ‘0-observations’ for fares>i,
which would drive demand estimates for
higher fares down. Demand estimates for
fares<i are not disturbed, because tradi-
tional forecasters apply unconstraining. In
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Dynamic pricing — A future airline business model
this particular context, this would mean no
updates for demand estimates. The latter
assumption leads to the ‘self-fulfilling pro-
phecy’ that there is demand for the lowest
fare only. This underestimation of high
yield demand is also referred to as ‘spiral
down effect’ in airline revenue manage-
ment (Cooper et al., 2004).
ANALYSIS OF DYNAMIC
PRICING PERFORMANCE
In this section, the empirical performance
of the above dynamic pricing model is ana-
lysed. The performance of the prototype
model is evaluated in two steps:
(1) model adequacy
(2) analysis of performance under competi-
tion.
Model adequacy
To give evidence of the adequacy of the
proposed dynamic pricing model, the latter
has been building up in a multistage simu-
lator, giving the possibility of comparing
the results obtained against the optimal
revenue management strategy. To evaluate
the validity and reliability of the dynamic
pricing methodology described, a standard
demand situation is simulated, and the per-
formance of the dynamic program is com-
pared with the optimal strategy in given
circumstances. The chosen parameters for
the simulations are a capacity x of ten seats
and a total time for sale T of 100 period
slices. A discrete set of ten allowable prices
is given from which the seller can choose.
The price range is defined between 99CHF
and 599CHF per seat and leg. The custo-
mer reservation price is exponentially dis-
tributed, and the simulator randomly
generates arrival rates. It is clear that the
dynamic pricing methodology tested has
no initial and direct access to these market
data.
The sample size of each simulation run
was 1,000. In each simulation run, the
Page 44
starting values required that the dynamic
program was randomly generated. To cor-
rect this, a ‘burn period’ of 50 trails was
subtracted before comparing the results.
For the given capacity of ten seats, a
demand with a base rate of 0.2 is simulated.
This base rate is equal to a number of 20
customers willing to purchase a seat on this
leg if the offered fare is equal to or lower
than the prospective reservation price.
After 1,000 simulations under the given
parameters (and after subtracting the burn-
ing period), dynamic pricing generated an
average revenue of 3,382CHF per leg. This
revenue is equal to an average yield of
338.2CHF. The optimal strategy provided
by the multistep simulator, knowing all
market and customer parameters, generated
an average of 3,416CHF per leg or a yield
per passenger of 341.6CHF. Under the
simulated demand situation, dynamic pri-
cing leads to a decline of 0.9 per cent with
a standard deviation of 0.61 per cent of
total revenue compared with the optimal
strategy.
Under the given situation, the dynamic
program calculated an average ‘starting
fare’ of 299CHF. As sales move further,
however, and depending on the seats
already sold, the optimiser starts to open
fares at 349CHF. Towards the end, the
dynamic program computes an optimal
fare of either 299CHF or 499CHF, depend-
ing on the remaining capacity, the
observed demand and the remaining time
to departure. Both the booking profile and
the specific demand for each fare class
show a similar picture (Figure 2).
Considering the demand situation and to
maximise revenues, it is obvious that
higher fare levels are sold. At the same
time, it is important to sell as many seats as
possible. Therefore, an exact estimation of
the future demand is very important to sell
at the right price to maximise revenues. In
the simulation described, the dynamic pri-
cing model underestimated demand at
 Burger and Fuchs

Figure 1: Fare distribution

10
9
Fare 299
8
7
6
Capacity x

Fare 349
5
4
3 Fare 399
2
1 Fare 499
0
0 10 20 30 40 50 60 70 80 90

Period slices T

Fare at capacity x and periode slice T

lower price levels and overestimated level of 299CHF. The main reason for this
demand at higher fares. Compared with is the starting problem. Without precise
the optimal booking profile, the dynamic market information, the dynamic program
program allowed too many bookings at needs a certain number of observations to
the prices of 349CHF and 599CHF. In con- estimate and forecast the market demand
trast, it did not catch the demand at the precisely at each price level to open the

Figure 2: Booking profile

Simulated and estimated demand

99 149 199 249 299 349 399 449 499 599

Price set f1, …, f10
Estimated demand
Simulated demand
Booking profile ‘dynamic pricing’
Booking profile ‘optimal solution’

Page 45
Dynamic pricing — A future airline business model
right number of seats to optimise total rev-
enue. At the starting point, this market
information is missing, and the probability
is very high that the dynamic pricing
model is starting with an inappropriate fare
level. As sales move further, the model
gains access to actual market dates and is
fine tuning its forecast in every time slice
and after each sale, resulting in a precise
estimation. Owing to this dynamic learn-
ing effect, the system is getting better as
more customers are observed.
The convergence of the total revenue
curves affirms the truth of this statement:
the dynamic pricing model badly under-
performs compared with the optimal solu-
tion at the first simulation sample. After
the ‘burn period’ of 50 samples, the perfor-
mance of the dynamic program is already
very close to the optimal revenue path
given by the simulator. After 100 samples,
the dynamic pricing model estimates and
acts nearly optimally (Figure 3).
Feeding the dynamic program with
actual market data (ie demand distribution
and/or reservation prices) minimises the
Figure 3: View path
3000
Total Revenue Jt(x)
2000
1000
100
Average Revenue ‘optimal solution’
Average Revenue ‘ dynamic pricing’
Burn period
Page 46
convergence period and protects the model
from ending up in a self-fulfilling pro-
phecy. As already stated, market research
of historical data is helpful to increase the
performance of the dynamic pricing meth-
odology.
The proposed dynamic pricing metho-
dology performs in the described environ-
ment unexpectedly well. Different trails
with other settings showed similar results.
Under the assumption of appropriate start-
ing values, the dynamic program con-
verged after a short ‘learning period’ to the
optimal solution. After the subtraction of
the so-called learning period, the proposed
dynamic pricing model led to an average
total revenue deviation of –1.32+0.76 per
cent compared with the optimal solution.
Some rare cases have been observed
where the dynamic program ended up in a
self-fulfilling prophecy. This can be traced
back to unfortunately generated starting
values where the estimator determined that
all probabilities are zero expect for the
lowest price. The model then displayed the
lowest fare only and never corrected those
200 300 400 500 600 700 800 900 1000
Simulation simple

estimates. It is believed that heuristic start-
ing values are preventing modelling from
ending up in this self-fulfilling prophecy.
Analysis of performance
under competition
In August 2003, Swiss International Air
Lines implemented an adapted prototype-
model for dynamic pricing into their
revenue management system within the
European markets. As a result, ten addi-
tional new fare classes were introduced,
mainly differentiated over the fare. The
introduced dynamic pricing methodology
computes the optimal fare according to the
observed demand and opens one for the
new fare classes. The re-optimisation is
done every 24 hours, and the first p(f) is
heuristically estimated by historical data,
market surveys and competitor analyses.
To study the performance of the
dynamic pricing strategy under competi-
tion, a particular 300 mile single-leg Euro-
pean market characterised by 13 daily
connections resulting in a big over-capacity
was analysed. In this market, three different
airlines with different revenue management
strategies are competing. The performance
of dynamic pricing is then derived from
the total revenue generated for each flight
and compared against previous years’ fig-
ures. The compared figures are adjusted by
the market grow rate and the available seat
(MIDT, 2004). It should be stated that rev-
enues and seat load factors were available
only for airline A. Thus, figures from air-
lines B and C were estimated and deviated
from public data.
Airline A (Swiss International Air Lines)
has six daily connections and uses the
described dynamic pricing strategy. Air-
line B has three daily services and is using
traditional revenue management. Airline C
is a low-cost carrier with four daily flights.
The departure schedules of the three air-
lines are shown in Table 1.
In the analysed period of September and
Burger and Fuchs
Table 1: Departure schedules GVA-PAR
(Geneva–Paris)
A B C
Dep. Dep. Dep.
06:50 07:30 06:10
09:00 – 09:40
11:35 12:00 –
15:55 14:00 15:55
18:15 – –
20:05 – 20:10
October 2003, airline A accounted a 2.4
per cent increase of total revenue compared
with the previous year. The average seat
load factor (ie the ratio of transported pas-
sengers and total seats) rose by 6.3 per cent.
From the point of view that the capacity
remained unchanged and the market grew
by 0.06 per cent compared with the pre-
vious year (MIDT, 2004), this is a signifi-
cant improvement in the result and may be
traced back to the revenue management
method.
An analysis of the different flights shows
that the performance of dynamic pricing
strategy largely depends on the competi-
tors’ revenue management systems. The
highest revenue increase can be shown in
the situation where dynamic pricing is
competing against traditional revenue man-
agement. Thus, the largest effect can be
shown on the midday flight (eg departure
11:35/12:00), where airline A is competing
against airline B, using traditional revenue
management. The dynamic pricing strat-
egy of airline A resulted in a revenue
increase of 12.1 per cent, and the average
seat load factor rose in the analysed period
by 18.5 per cent compared with the pre-
vious year. The reason for this unambigu-
ous result can be directly traced back to the
fast adaptation of dynamic pricing on the
market. It was observed that airline A
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Dynamic pricing — A future airline business model
undercut the fare offered from airline B
during the whole booking period and so
attracted additional passengers. Shortly
before departure and at days where air-
line A risked being sold out, the dynamic
pricing methodology increased the offered
fare over proportionally, while airline B
still sold lower fare classes. Considering the
marginal market growth, it is assumed that
airline B lost passengers and revenues
(MIDT, 2004).
A different picture was observed for
morning and evening flights (eg departure
09:00/09:40 and 20:05/20:10), where airline
A was competing against airline C. The
revenues of airline A did not increase sig-
nificantly, and the average seat load factor
rose by 5.8 per cent. Analysing this situa-
tion shows that the dynamic pricing model
was undercutting the fare offered from the
low-cost carrier C. But in this case, the
fares were at the lower end, slightly above
the marginal cost. It is believed that owing
to the lower average fares, additional low
yield traffic was attracted, resulting in the
rise in seat load factor. In contrast, the
effect of the increased seat load factor was
not strong enough to have a significant
positive impact on revenues. It is assumed
that at very low price levels, passengers are
less price sensitive to relative changes and
convenient factors such as time of depar-
ture or image of the airline become more
important (Holloway, 2003). Finally, ana-
lysing the early morning flight and the
afternoon flights (eg departure 06:50 and
15:55) of airline A showed a similar pic-
ture. The effect of the decreased fares had a
direct positive impact on the seat load
factor. In turn, the increasing seat load
factor was not always strong enough to
compensate for decreasing yields, so having
a positive effect on revenues.
This outcome leads to the question of
what would happen if two competing air-
lines applied dynamic pricing methodolo-
gies. Following the dynamic pricing
Page 48
strategy, both carriers would start dynami-
cally to undercut each other without seeing
an effect on demand. The dynamic pricing
methodology will, under the situation of
over-capacity, dynamically continue to
undercut prices. The resulting spiralling
down effect can be explained using Ber-
trand’s paradox (1903): if one airline is redu-
cing the price to attract passengers, the
other airline will reduce its price even more
to attract passengers back. The result is a
price war. Typically, the price war would
not stop until both of the competitors
ended up on the lowest price level — below
marginal costs. Since it makes no sense eco-
nomically to sell below variable costs, mini-
mum price thresholds are required. Price
thresholds are strongly connected to the
cost structure of the airline — defined by
the short-run marginal costs (SRMC) per
passenger. Obviously, the more competitive
the cost structure of an airline the better the
dynamic pricing system performs. There-
fore, airlines with lower production costs
will be able to match or even undercut the
competitor’s price and will still be able to
generate small margins.
Furthermore, within so-called ‘indiffer-
ence zones’, customers are indifferent to
small pricing changes where, outside this
zone, demand rises or falls dramatically in
response to price changes (Elmaghraby and
Keskinocak, 2002). Decreasing prices
below a certain point, however, does not
have a significant impact on purchase.
According to Barker et al. (2001), prices
for well-known brands can be raised as
much as 17 per cent without a change in
consumer reaction. Hence, it is believed
that a thorough understanding of demand
elasticity may also help airlines to set effi-
cient price thresholds and prevent the
system from ending up at the lowest price
level.
To sum up, dynamic pricing has a neu-
tral or positive effect on the airline’s rev-
enue under the assumption of a

competitive cost structure. A carrier using
dynamic pricing competing against a car-
rier doing traditional revenue management
will see an increase in revenue. This
increase is based on the better adaptation of
dynamic pricing to the environment due to
the dynamic booking policy.
The drawback of dynamic pricing lies in
the situation where two competing carriers
use dynamic pricing strategies. Setting
minimum price thresholds, however, will
prevent the system from ending up in Ber-
trand’s paradox (ie ending up on the
lowest price level). Nevertheless, in this
specific situation the dynamic pricing
model underperforms compared with tra-
ditional revenue management.
ECONOMIC EFFECTS IMPLEMENTING
DYNAMIC PRICING
To date, research on dynamic pricing has
only explored revenue impacts. Hence, the
next section is intended to show that
dynamic pricing may also lead to a signifi-
cant cost reduction. Put differently,
dynamic pricing is the starting point for a
strategic position based on distinctiveness
and cost leadership, allowing an airline to
distinguish itself from competitors.
Strategic management literature widely
accepts that competitive advantages are
derived from the ability to provide better
customer value for equivalent cost, or
equivalent customer value at lower cost
than competitors (Porter, 1985). To
achieve either of these advantageous posi-
tions, a company chooses to perform parti-
cular activities in a certain way or to
produce those activities in a particular (ie
highly efficient) manner (Porter, 1991,
1996). Strategic positioning is underpinned
by relevant resources and competencies
which allow it to distinguish itself from
competitors in respect of what a company
can do and how it can be done. Hence,
resources brought together in the context
of particular core competencies and cost
Burger and Fuchs
positioning are considered as the base of an
airline’s ability to differentiate itself.
The application of the price elasticity
approach discussed above instead of restric-
tions to control capacity in order to opti-
mise revenues will dramatically redefine the
qualitative characteristics of an airline
ticket. A purchasing passenger will be faced
with only one price for his desired journey
— the complexity of combination of fare
and different restrictions used by today’s
revenue management will disappear. It is
expected, however, that any reduction in
the complexity of a ticket purchasing pro-
cess will lead to increased customer value.
Low-cost carriers, for example, have
proved that customers appreciate simple
ticket rules and fast purchasing processes
(Hurumi and Darin, 2003). It is believed
that the application of dynamic pricing and
the resulting drop out of restrictions will
have three major economical advantages
leading to significant cost reductions.
Simplified web applicability
Today, concepts of ticket restrictions are
based mainly on two pillars: advanced pur-
chase and minimum-stay restrictions. It is
clear that minimum-stay restrictions are
strongly related to the return ticket, so it is
clear that one-way fares must be set high
enough to not over-rule other restrictions.
As stated, dynamic pricing suggests a way
of controlling capacity only over the price.
It is easy to see that the disappearance of
restrictions due to dynamic pricing makes
one-way pricing possible. Outbound and
inbound journeys are priced separately but
remain fully combinable. It is further
believed that one-way pricing will increase
the transparency of ticket fares, supporting
fast and well-accepted ticket-purchasing
processes. Furthermore, one-way pricing
has the great advantage that fares can be
easy and understandable displayed in a
two-dimensional way (ie flight and corre-
sponding fare) on the internet. It is
Page 49
Dynamic pricing — A future airline business model
assumed that the introduction of a simpli-
fied and easily understandable ticket pur-
chasing process may support a shift of
volume into direct sales channels. There-
fore, it is believed that customers will be
more willing to make use of own sales
channels, call centres or web-sales. Low-
cost carriers prove that it is possible to sell
out an aircraft only via direct channels
(Lawton, 2002).
Disengagement from travel agents
Airlines have the choice between two basic
distribution strategies (Bouvard and
Somosi, 1997). Either they continue to rely
on distributors to push their travel services
to the passenger by offering bonuses to
travel agencies, or they may choose a ‘pull’
strategy, and rely on their own product,
brand name and/or marketing skills to gen-
erate customer demand and loyalty to
maintain or develop their market position
(Bouvard and Somosi, 1997). In a liberal-
ised market distribution, with the first
strategy, costs could quickly escalate if
competing airlines begin raising overrides
to win business. The second strategy is
reducing an airline’s dependence on travel
agents to market its products.
Until today, all major network carriers
have relied on external sales channels (eg
travel agents, consolidators or tour opera-
tors) to distribute up to 85 per cent of the
airline tickets (Costa et al., 2002). Travel
agents are adding value by providing infor-
mation about travel options, making airline
reservations and airline seat selections, issu-
ing tickets and tracking travel expendi-
tures. For each booking, travel agents
collect a commission from the airline. In
addition, travel agents get bonuses and
overrides for meeting sales goals. Today,
commissions and incentives add up to 8–12
per cent (eg IATA is suggesting 9 per cent)
of the ticket price (Hecker and Steve,
2003). Futhermore, computer reservation
systems (CRS) serve travel agents with a
Page 50
repository of capacity information and
offer a range of services, such as providing
real-time information about seat availabil-
ity and handling computerised requests for
seats. Industry research from the US Gen-
eral Accounting Office (GAO) shows that
CRS account for 3–5 per cent of the ticket
price (Hecker and Steve, 2003).
In the age of the internet, the added
value from CRS must be strongly put into
question. More precise CRS are unable to
display dynamic fare changes. Direct access
to airlines’ booking servers becomes indis-
pensable. It is believed that, under the
application of dynamic pricing, the loop
over a CRS may be inefficient and unne-
cessary. An even bigger potential threat lies
in airlines’ efforts to redefine the travel
agents’ role and to bypass them. It is
assumed that to purchase a ticket with only
one fare and no restrictions does not need
support from a travel agent. Furthermore,
travel agents have to book the dynamically
priced ticket directly over the web server
of the airline — in the same way as every
customer can book tickets. Applying
dynamic pricing must lead to a redefinition
of the role of the travel agent. It is assumed
that the resulting cost saving from bypass-
ing travel agents and CRS companies adds
up of more than 5 per cent of the ticket
price (Bouvard and Somosi 1997).
In addition, the development of a direct
relationship with customers will give air-
lines a firmer grip on sales. A closer rela-
tionship with the customer will help to
eliminate being at the mercy of distributors
and intermediaries. The airline develops its
internal distribution structure to handle an
increasing share of ticket distribution in
certain, well-defined customer segments,
shifting volume from unfocused and some-
times unprofitable ticket offices to high-
performing call centres and web sales. In a
deregulated market, a pull strategy is
clearly superior, as customer loyalty will
prevent an airline’s home market eroding

while limiting the bargaining power of
travel agents (Holloway, 2003). A pull
strategy clearly relys on a fast ticket pur-
chasing process in conjunction with a two-
dimensional decision structure.
Decrease in complexity and
transaction costs
Today’s revenue management consists of
two components: pricing differentiation
and reservations control (Belobaba, 1987).
Price differentiation is the process by which
fare levels are defined and combined with
different restrictions. Subsequently, reserva-
tion control allows the optimal number of
seats to be allocated to each defined fare
level (ie represented by booking classes) to
optimise revenues. Dynamic pricing sug-
gests a new approach to controlling capa-
city and optimising revenues. Instead of
imposed restrictions, the offered price level
affects customers’ purchase behaviour in
order to control seat allocation. Conse-
quently, today’s pricing activities may be
abolished — pricing management and
reservation control departments may be
merged. By doing so, dynamic pricing will
lead to a direct decrease in complexity and
transaction cost within an airline’s organi-
sation structure (Williamson, 1993).
CONCLUSION
In today’s competitive environment, an
airline can achieve advantage over compe-
titors by taking an aggressive approach
towards reducing the role of travel agents
and intermediaries for ticket distribution.
Applying the advantages of dynamic pri-
cing to the distribution chain is making the
added value from travel agents question-
able. The introduction of a simplified and
effective ticket purchasing process as gener-
ated by dynamic pricing will support the
shift of volume into direct channels. Ticket
sales over the airline’s own channels, such
as web sales or call centres, are becoming a
Burger and Fuchs
more valid alternative to external distribu-
tors. Low-cost carriers prove that it is pos-
sible to sell out an aircraft via direct
channels (Lawton, 2002). The closer rela-
tionship with customers will help stop air-
lines being at the mercy of distributors and
intermediaries. Put differently, distributions
via the airlines’ own channels are bypassing
travel agents and consequently CRS com-
panies. The savings from direct sales will
be significant, and service can improve. It
is questionable, however, that dynamic pri-
cing itself will make all passengers use
direct sales channels. Dynamic pricing gen-
erates only the base situation, where direct
sales become simpler and more effective.
Once direct sales channels are implemented
and accepted by customers, ticket prices
from external channels may be increased
by CRS and travel agent commission. In
other words, customers who require ser-
vices from travel agents would have to
cover the expenses arising.
This paper has shown that an airline
employing dynamic pricing and competing
against a carrier employing traditional rev-
enue management will recognise a signifi-
cant revenue increase. On a short-term
view, revenue wins through dynamic pri-
cing can rise by up to 20 per cent. This
increase is based mainly on the better adap-
tation of dynamic pricing to the environ-
ment. This better adaptation can be traced
back to the fact that dynamic pricing
methods do not determine booking control
policy at the start of the booking period as
the static methods do. On a long-term
view, however, the revenue effect will be
much lower or neutralised through the
adaptation of the competitors’ strategy.
The drawback of dynamic pricing lies in
the situation where two competing carriers
are using dynamic pricing strategies. Set-
ting minimum price thresholds, however,
may prevent the system from ending up in
Bertrand’s paradox. Nevertheless, in this
specific situation, the dynamic pricing
Page 51
Dynamic pricing — A future airline business model
model still underperforms compared with
traditional revenue management.
On the cost side, dynamic pricing is also
generating organisational benefits leading
to a significant decrease in complexity and
transaction costs. Additionally, the arising
simplification of ticket purchase processes
leads to added value for customers and is
making today’s role for travel agents
highly questionable. A shift in volume to
internal sales channels will result in better
service and lower distribution costs. At the
bottom line, a potential decrease in cost by
more than 5 per cent may be expected
(Bouvard and Somosi, 1997). Thus,
dynamic pricing will lead to an overall
increase in profitability. Customers are get-
ting offered seats for a dynamic market
price, as lower willingness to pay is
demanding higher seller flexibility. In
other words, you get what you pay for!
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